Banking

Money markets seek new 'normal' in Lehman aftermath

WilliamL. Watts

LONDON (MarketWatch) -- You don't hear money-market terms such as Libor and the TED spread being thrown around on evening newscasts these days. And that's a good thing.

The collapse of Lehman Brothers a year ago, in September 2008, thrust the arcane but crucial workings of the money markets into the spotlight as the global financial system nearly froze solid, risking a worldwide financial cataclysm.

Markets went from "acute distress to absolute and utter Armageddon. ... We got very close to it, anyway," recalled Russell Jones, head of fixed income and currency research at RBC Capital Markets.

Terms such as Libor, or the London interbank offered rate, and the TED spread, the gap between the three-month T-bill interest rate and three-month Libor, became front-page news. The VIX index
VIX, +32.45%
a measure of volatility in the options market, was followed closely as Wall Street's de facto fear gauge.

Money markets, meanwhile, were at the center of the crisis in Lehman's immediate aftermath. While obscure to most consumers and casual investors, they are crucial to the functioning of the financial system. Banks borrow short and lend long, and they need to be able to access a ready pool of credit to meet short-term funding obligations.

The stakes were high. In the worst-case scenario, the freeze in interbank lending could have pushed many banks toward collapse as they failed to meet normal, short-term funding needs. The lack of liquidity could add to the downward spiral across asset classes.

Libor, compiled daily by the British Bankers Association, is the most widely used benchmark for short-term interest rates around the world.

In contrast to a year ago, short-term Libor borrowing rates in dollars, euros and British pounds have been notching new all-time lows recently. The rates would be expected to be historically low, given that official interest rates are also at all-time lows and central banks appear unlikely to significantly unwind massive efforts to provide liquidity to the financial sector any time soon.

What's important is Libor's relationship to official interest-rate expectations. If Libor is rising even as central banks cut rates, it's a sign that banks are hoarding cash.

Libor soared last fall. Moreover, the spread between Libor and expected official interest rates, a gauge of banks' willingness to lend to each other, went through the roof.

The spread between dollar Libor and the expected federal funds rate widened to a peak of 366 basis points in early October, according to inter-dealer broker Tullett Prebon. The gap, known as the Libor/OIS spread, had averaged just 11 basis points from 2002 to July 2007, according to Dow Jones Newswires. From the start of the financial crisis in August 2007 until the Lehman collapse in mid-September, the spread had averaged 68 basis points.

Libor-OIS moved back to below 20 basis points in August and slipped just below 15 basis points Thursday.

The TED spread, the most closely watched gauge of banks' willingness to lend to each other, also has moved far off crisis levels. The spread peaked in October at more than 460 basis points, according to FactSet Research.

By late July, it had slipped below 30 basis points for the first time since March 2007. On Friday, the TED spread was seen at 18 basis points.

Market participants, however, say there is less than meets the eye to improvements in the money markets. And it could be years before conditions are anything like those seen before the financial crisis took hold more than two years ago.

"Money-market conditions are far from normal," said Don Smith, an economist at interbank broker ICAP. "It's taken the enormous presence of the central banks in the money markets" to foster any improvement.

Central banks flooded the global financial system with liquidity, effectively stepping in to provide the short- and medium-term loans to ensure the markets continued to function. The U.S. Federal Reserve's balance sheet stands at more than $2 trillion.

Central banks also slashed interest rates. And the U.S. Federal Reserve and the Bank of England embarked on a policy of quantitative easing, effectively creating new money in an effort to stimulate spending and avert a deflationary spiral.

The ECB, on top of other aggressive liquidity measures, in June lent banks 442 billion euros at a 1% interest rate and is set to offer more one-year funds later this month.

Nevertheless, volumes in money markets remain very low and are still very "name-specific," Smith said, meaning that banks are wary about whom they lend to in the interbank market. Lending is tight beyond the very-short-term horizon, and there are also wide spreads between "top tier" and "lower tier" markets, he said.

And banks have hardly been eager to lend, instead hoarding reserves and leaving a large chunk of them on deposit with central banks as they seek to repair their own balance sheets.

"I think we are not completely back to normal, but the question is how do you define normal," said Ian Harnett, joint managing director at Absolute Strategy Research.

Harnett and other economists say the days of historically easy credit that prevailed before the credit crunch began to take hold in 2007 were abnormal in themselves.

The aggressive policy response, along with massive stimulus efforts and taxpayer-funded bank-rescue efforts, has helped fuel a rebound in risk appetite. The dollar surged last fall as investors shunned risk and sought safety in perceived havens such as the dollar and the Japanese yen.

Rising risk appetite has left the greenback on the defensive since March, while equity markets around the globe have rebounded strongly.

Meanwhile, Chicago Board Options Exchange Volatility Index, widely known as the VIX and closely followed as the market's de facto fear gauge, dropped back to pre-Lehman levels earlier this summer as the equity rally from March lows gathered strength.

The index peaked at 80.86 in November, according to Bloomberg, and fell below 30 in May for the first time in eight months. The index reached an intraday record high of 89.53 on Oct. 24.

Unsurprisingly, financial-sector stocks were drubbed as the overall market tanked last fall. But despite their crippled status, banks have also helped lead the partial recovery that's taken hold since March.

In Europe, the Stoxx index of European banking stocks on Friday was up by around 49% for the year to date but remained around 21% below levels seen a year ago. The SPDR KBW banking ETF, which tracks the U.S. financial sector, trimmed gains in the past week to remain up about 1.7% since the start of the year, while still down more than 30% compared with last autumn.

The financial sector has "essentially been given free money, and it's worked," Harnett said. "The yield curve has steepened substantially, and banks have started to recapitalize themselves slowly and painfully, and eventually they will begin to lend more aggressively the reserves that currently are being held by the central banks."

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